Dec

30

Rolling the Position, Call & Put Spread

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Rolling the Position
Time spreads are unlike all the other strategies in regards to rolling or continuing the position. In other strategies, the option component is limited to a single month. The position disappears at expiration. It either transforms into stock or expires worthless leaving you with no option position. This is not so in the case of a time spread where you are dealing with two different expiration months.

After the front month expires, in addition to a potential stock position, you still have an option position. The out-month option still has time until expiration. You must first understand the new position you have inherited to properly roll it.

Rolling the Call Spread

Look at the call time spread first. For the purposes of our example, pretend we are long the September / October 25 call spread. If the stock closes below $25.00 on expiration Friday of September, the September 25 calls will expire worthless leaving you with a long October 25 call position. You have several things that you can do from this position.

First, you can sell out the October 25 call. Perhaps, the combination of the expiration of the September 25 calls and their subsequent worthlessness along with the proceeds gained from the sale of the October 25 calls after September expiration might make a profitable trade.

You can also keep the position open and continuing in several ways. You can stay long the October 25 call naked. You can sell the October 30 call and become long the October 25 / 30 vertical call spread if you are bullish. You can sell the October 20 call and become short the October 20 / 25 vertical call spread if bearish.

You can buy the October 25 puts and become long the October 25 Straddle if you feel the stock would become volatile. You can even sell the stock and create a synthetic put if you are very bearish. There are ways to create a new position that reflects any possible outlook an investor has.

If the stock closes above $25.00, then the September 25 call will close in-the-money. At that time, you will be assigned your short September 25 call and that translates into a short stock position. The short stock position that you receive from the assignment of your short September 25 call, along with the remaining October 25 long call position, is the equivalent of a synthetic put. At this time, you can close out the position or keep it.

The position is a bearish one, so if you feel the stock may head down, you can keep the position on. You can sell another option of a different strike to set up either a bull or bear put spread. You can buy the October 25 call to create a long Straddle. As you see, many different combinations are available.

If you are short the September / October 25 call time spread and the stock expires under $25.00 on expiration Friday in September, then you will have a remaining position of a short October 25 call naked. There are many potential ways of continuing the position. You can always buy back the naked call and close the position if you no longer want to maintain a position in the stock.

If you do, you can buy a call in the same month and create a vertical spread, sell the corresponding put and create a short Straddle, buy the stock one-to-one and create a buy-write or other combination based upon what you feel the stock will do.

If the stock closes above $25.00 and you are short the call time spread, you will have with a long stock position from your long September 25 call and short the October 25 call against the long stock position. The position that remains is a buy-write. Depending on your outlook for the stock, you can keep the buy-write on, take it off or use other options to change the position to what you want it to be.

Rolling Put Spreads

Let us see where we are when the front month option expires. We will use the September / October 25 put spread for our example. When long the spread, and the stock closes above $25.00, the September 25 puts, which you are short, will expire worthless leaving you with a long naked put position. From that position, you can close it or combine it with other option or stock to create a different position. Again, there are many different possibilities.

If you are short the put time spread, and the stock closes above $25.00, then the September 25 put (which you are long) will expire worthless leaving you with a short naked put position in the October 25 puts. This position may be closed out or combined with other options or stock to create a strategy, which will take advantage of the outlook you have on the stock.

When the stock closes below $25.00, the scenario is different. When long the spread with the stock closing lower than the strike price, the front month put which you are short will be assigned to you thus making you long stock in addition to your long October 25 put. This position is known as a synthetic call.

There are many ways to combine other options and/or stock to change the position so that it is in line with what you want it to be going forward.

If you were short the spread, and the stock closed below $25.00, then you would exercise your long September 25 put making you short stock and short the October 25 put. That position, which is called a “sell-write” (the sister strategy to the buy-write), can be kept as is, closed out, or changed in different ways by combining it with stock or other options based upon your expectations of the stock’s future movements.

Closing the Time Spread Position

It is important to remember that the time spread will leave you with several potential positions that can be altered by other options or stock in numerous ways. There are a number of decisions you must make to clarify your understanding and goals.

First, it is important to understand what position remains when the near-month option expires. Second, you must decide what you think the stock is going to do (formulate a bullish or bearish lean) and then figure out the best way to take advantage of that opinion. Next, you must figure out how to adjust your present position and change it into an advantageous one for a profitable outcome. That might mean selling out of the position totally. Your changes to the position must not only be correct, but also done in the most efficient, cost-effective manner including keeping commission prices down.

It is also important to note that you should go from one hedged position to another to ensure proper risk management.

The time spread is an excellent strategy for premium sellers who want to capture premium in a hedged way. It is ideal for stagnant periods when a stock is likely to remain in a tight price range. Time spreads are less expensive and less risky than almost all other premium collecting strategies, so it is friendlier to investors who are short on capital and experience. Time spreads can also take advantage of volatility changes and even some directional stock movements.

The time spread can leave you with a residual naked position, which needs to be managed for risk at expiration of the front month option. It is important to fully understand the risks and rewards of the strategy and the potential risks and solutions of the residual position before execution.

The residual position affords you many choices including closing out the position totally, or continuing the position by combining it with either stock or another option to create a new position that fits the investor’s new expectations for the stock.

Dec

29

Market Talk December 25, 2007

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Part 1

Part 2

Dec

29

Seller Risk & Reward

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The seller of a time spread buys the nearer month option and sells the outer-month option in a one-to-one ratio. To profit from the sale of the time spread, the seller must look for two things.

The first is a decrease in implied volatility. As volatility decreases, the out-month option (which the seller is short) loses money faster than the near month option (which the seller is long) because of the higher Vega in the out month option. This will cause the spread to contract or lose value and will be profitable for the time spread seller.

The second thing a seller should look for is a movement in stock. A time spread is at its widest, most expensive point when it is at-the-money. A movement away from the strike in either direction decreases the value of the spread. As long as the stock moves in either direction away from the strike, the seller’s position could be profitable if time decay does not outperform the stock movement.

Time, unfortunately, never works in favor of the time-spread seller. The nearer month option (which the seller is long) naturally decays at a faster rate than does the out-month option (which the seller is short). These differing decay rates cause the spread to expand and increase in value, which produces a loss for the time spread seller.

Increases in implied volatility are also detrimental to the potential profits of the time- spread seller. When implied volatility increases, the out month option (which the seller is short) increases in value faster than the near month option (which the seller is long). This is due to the out month option’s higher Vega which creates an expansion in the spread and increases its value resulting in a negative for the spread seller.

The seller, in theory, has an unlimited loss potential. The maximum loss potential is not so much determined by the stock price movement but by the movement in implied volatility. As the seller, you will be long the front month call and short the out-month call.

The out month call will be more sensitive to movements in implied volatility due to a higher Vega or volatility sensitivity component. If implied volatility increases, then the seller’s short, out month option will increase more in value than will the seller’s long, front month option. This will cause the spread to widen or increase in value – a negative for the seller.

The second risk is that the option the seller is long is going to expire approximately 30 days prior to the option the seller is short. If volatility does not decrease or the stock does not move away from the strike significantly before the seller’s long option expires, (s)he will be left short a naked or un-hedged option and a loss on the position.

If the seller can wait out the position, the lost extrinsic value of the short option is retainable. This option also has a limited life and must shed its extrinsic value, no matter how much, by its expiration. The problem facing the seller is that the position is no longer hedged and the seller now faces unlimited risk.

Once the long option expires leaving the seller short a now naked call, stock price movement in the wrong direction is a substantial risk and under the circumstances described above, a big problem.

While the seller can wait out an implied volatility movement that created an increase in extrinsic value, they will probably not be able to wait out a large, negative stock movement creating an increase in intrinsic value. In that case, the seller must take action to prevent substantial losses once the front month expires. Attention to the implied volatility in the farther out option when the nearer month option expires can save the seller from a large loss.

Dec

28

Buyer Risk & Reward

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Like most trades, time spreads have a maximum loss for the buyer. You can only lose what you have spent. If you paid $1.00 for the spread, your maximum potential loss is $1.00. If you bought the spread for $2.00, the maximum potential loss is $2.00.

The buyer of a time spread will purchase the out-month option while selling the nearer month option of the same strike in a one-to-one ratio. Since the out-month option will have more time until expiration than the nearer month option, the out-month option will cost more. This means the buyer will put out money (debit spread) that makes sense. The buyer can only lose the amount of money they spent to purchase the spread. Thus, the buyer’s maximum risk is the cost of the spread.

The buyer can profit in several ways. First, as a time spread, the buyer can profit by the passage of time. Options are wasting assets. As the nearer month option decays more quickly than the outer-month option, the spread widens (increases in value) and the buyer sees a profit.

Second, implied volatility can increase. As implied volatility increases, the out-month option, which the buyer is long, increases in value more quickly (due to its higher Vega) than the nearer month option that the buyer is short. This will force the spread to widen or increase in value, which again is profitable for the buyer.

Third, the buyer can make money due to stock price movement. As stated before, a time spread’s value is at its maximum when the stock price and the spreads strike price are identical (at-the-money). You can have an increase in value if you own an out-of-the-money or in-the-money time spread, and the stock moves either up or down toward your strike. As the stock moves closer to your strike, the spread will expand and increase in value creating a profit for you, the buyer.

The buyer’s risks are obviously the opposite of the rewards. You cannot stop or reverse time, so the buyer of the spread can never be hurt by time. Implied volatility, however, can decrease as easily as it can increase. A decrease in implied volatility will decrease the value of the out-month option (which the buyer is long) faster than it will decrease the value of the nearer month option (which the buyer is short) due to the higher Vega of the out-month option. This will narrow the spread thereby creating a loss for the buyer.

In the same way that stock movement in the right direction can be profitable for the buyer of a time spread, stock movement in the wrong direction can be costly. As the stock moves away from the spread’s strike, the spread decreases in value. That will create a loss for the buyer of the spread.

Dec

27

Behavior of the Time Spread

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Time spreads can be a profitable investment strategy if you understand the concept of time decay. A time spread is designed to take advantage of the fact that an option’s decay curve is non-linear, that is, an option’s value does not decay evenly over time. As an option gets closer to expiration, its rate of decay increases meaning the option loses value more quickly. That decay rate increases progressively until expiration.

An option’s decay rate begins to accelerate when the option is about 45 days out. It picks up steam at 30 days out and really comes under decay pressure at about 15 days out. This scenario is similar to a boulder rolling down from a hilltop. As it starts, it rolls slowly, then gains more speed, and momentum the further it gets down the hill until it achieves its maximum speed at the bottom. Option decay acts the same way – gathering speed and momentum as the option approaches expiration.

In time spreads, both options have the same strike price that remains constant. Each option’s value decays at different rates and over different lengths of time. The option, with one month until expiration, experiences value decay at a faster rate than the one with three months until expiration.

If you buy an option with three months to go and sell an option with the same strike but with one month to go, you have set up a spread between the two options values (prices). As time passes, your short option loses value more quickly than your long option that decays more slowly. The value of the spread widens and you profit from that spread’s expansion. This is the fundamental behavior of the time-spread.

The above chart shows an option decay graph. The numbers across the bottom represent days to expiration. Along the decay line, you will notice an “X” at the 30-day to expiration line and another “X” at the 60-day to expiration line. The first “X” represents a 30-day option while the second “X” represents a 60-day option. If you look closely at this chart, you will see the nature of the time spread.

Consider that you are long the 60-30 day time spread. That means you are long the 60-day option and short the 30-day option. We will assign a price of $3.00 to the 60-day option and $2.00 to the 30-day option. Since you pay for the one and receive payment for the other, the bottom line cost of what you put out for the spread is $1.00.

Look at the slope of the line (representing decay) drawn from the 60-day option to the 30-day option. Compare the slope of that line to the slope of the line drawn from the 30-day option to expiration (Day 0). As you can see, there is a big difference in the steepness of the slope of the two lines. The slope of the line drawn between the 30-day option to expiration is much steeper than the slope of the line drawn from the 60-day option to the 30-day option.

These slopes show how the time spread works. During the first 30-day period, the 30-day option has a steeper slope, meaning a higher rate of decay. During that 30-day period, this option will go from $2.00 to $0. Meanwhile, the 60-day option, having a flatter slope, will not decay as quickly.

During the same 30-day period, it goes from $3.00 to $2.00. Remember, the spread’s bottom line cost was $1.00. The 30-day option (now expired) will be worth $0 while the 60-day option (now a 30-day option) will be worth $2.00. If you had invested in this spread, after 30 days decay you would be holding one option worth $2.00. The investment has provided a nice return!

This is an ideal situation. The stock price and volatility remain constant and you capture the decay. The time spread has worked just as it should. It does work that way sometimes, but nothing works as it should all the time. As we know, stock prices and volatility levels do not remain constant. They are always changing. In the time spread strategy, the investor must choose opportunities carefully. In addition to picking a stock that will be in a stagnant period, the investor should look for two other situations where the spread has profit possibilities: changes in volatility and to a lesser degree stock price movements.

Dec

26

Construction of the Time Spread

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Time spreads, also known as calendar spreads, are an ideal way to take advantage of time decay and changes in implied volatility. Time spread strategy focuses on the movement of time and volatility more than on the movement of the stock. Therefore, it is perfect for when you anticipate stagnant or explosive periods in a stock.

Time spreads, like other spreads, have their own risks and rewards. The risks are very limited for the buyer, but substantial for the seller. The seller’s risk can be avoided or contained with due diligence at the expiration of the near month’s option. Several strategies can affect the seller’s risk. The advantage of the time spread strategy is that the investor can pursue a time decay or volatility position without the large capital outlay necessary for the purchase of the stock.

The construction of the time spread involves the purchase of one option and the sale of another in different months with both having the same strike. You can construct a time spread using either two calls or two puts. A long time spread is constructed by purchasing the out month option and selling the nearer month option. For example, you buy the September 45 call, sell the August 45 call or buy April 30 puts, and sell February 30 puts. You can construct a short time spread by selling the farther out month and buying the nearer month. For instance, sell July 50 calls and buy May 50 calls.

The important elements in the construction of the time spread are: using two call or put options on the same stock, using the same strike for both, choosing different months for each and using a one to one ratio. A one to one ratio means that you must purchase one option for every one you sell or sell one option for every one you buy. A time spread can utilize any two months as long as it has the same strike price and the trade is in a one to one ratio.

Most time spreads are executed at-the-money because at-the-money options have the greatest amount of extrinsic value. An option’s extrinsic value is what decays over time. This is the basis of the time spread’s strategy. Since the time spread is built to take advantage of time decay, it is better suited for at-the-money options. This does not mean that you cannot use the time spread with in-the-money or out-of-the-money options. In-the-money and out-of-the-money options have less extrinsic value than at-the-money options.

The rate of decay of an in-the-money or out-of-the-money option with one month until expiration is still greater than an in-the-money or out-of-the-money option of the same strike that has three months to go before expiration. This being said, the time spread can be constructed using any option regardless if it is in, out, or at-the-money.

Dec

25

An Imaginary Spread Scenario

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We are going to put together an imaginary spread scenario and set it in real life events. Consider that, in October, you begin to hear about IJK stock. It looks interesting, so you use a variety of sources to learn about it. (News, charts, outside analysts, Internet research, etc.) From your investigations, you decide that this stock is poised for a strong upward move and you would like to take advantage of it. Each share is $50.00 and you question whether you want to put out the capital for enough shares to make the trade worthwhile.

Now is the time to investigate IJK spreads. Since you are bullish on the stock, you look into the bullish plays of the call spreads and the put spreads. You check the pricing of both since you know that implied volatility and time decay affect your purchase and selling price if you decide to sell out the spread before expiration.

Imagine that you set the spread’s maximum potential gain at $10.00 using our formula. Then you decide that you want to buy a call spread, so you buy 10 IJK Nov. 50 calls and sell 10 IJK Nov 60 calls. This is the Nov. 50-60 spread. The spread’s cost is $3.50, which means you pay $3,500 for the trade. This is inexpensive when you consider that 1,000 shares of IJK stock would have cost you $50,000! You will now wait and follow the stock price of IJK. If you hold the position to expiration, you face the following losses or gains.

If the stock does not move up as you expected and stays at $50 or decreases in value, your spread is worthless and you will lose the $3,500 that you paid for the spread. If the stock begins to move up, you will recoup your investment and move into profits. When the stock has moves up to $3.50, you are at the breakeven point. Every money advance after that represents profit. The chart below represents the spread’s losses, gains and your total profit.

This chart shows stock prices at expiration on Friday in November. Until then, the spread’s value fluctuates between $0 and its maximum (the difference between strike prices) of $10.00.

At any time until expiration, you can sell out of the spread, but what you receive for the price are influenced by implied volatility and time decay. That will change your profit or loss. If you hold the spread until expiration and your bullish lean proves true, your maximum profit on your $3,500 investment is $6,500.

You paid $3,500 for the spread and received $10,000 at expiration with the stock at $60.00. That represents a $6,500 profit, which is a 186% return. If you had invested $50,000 for 1,000 shares of IJK and at expiration sold the stock for $60,000, your profit is $10,000 for a 20% return.

For many investors the reward/risk scenario of the spread is attractive because investors can limit the capital at risk and the time of risk/reward exposure. The spread also offers protection if your lean is bullish or bearish. Finally, the spread has the potential of a large percentage return on investment.

Dec

24

Time Decay and Volatility Trading Opportunities

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The terms “bull” and “bear” are often associated with vertical spreads. This leads most people to think of vertical spreads as directional plays, which is true. Vertical spreads can also be used to take advantage of two other potential trading opportunities – time decay and volatility movement.

Using Vertical Spreads to Take Advantage of Time Decay

If you are looking for a fully hedged way to take advantage of time decay, a vertical spread can be an excellent tool. It has a limited profit potential, but a limited loss scenario for both the buyer and the seller.

At-the-money options have more extrinsic value than their similar month in-the-money or out-of-the-money options. Since it is an option’s extrinsic value that decays over time, you can set up a vertical spread by selling an at-the-money option and buying either an out-of-the-money option (creating a credit spread) or an in-the-money option (creating a debit spread). If the stock holds tight to the out-of-the-money option, the option’s extrinsic value will decay at a faster rate than the in-the-money option or out-of-the-money option. This is because the at-the-money option has more total extrinsic value to decay in the same amount of time as the others.

Creating the vertical spread by selling an at-the-money option and buying an out-of-the-money or in-the-money option as a hedge looks like a good idea. Now, there are a couple choices. Should you do the put or call spread? Should you buy or sell it? You should base your decision of what to do on which way you think the stock will move. Although you are playing for time decay and you are assuming an overall lack of movement, you cannot expect the stock not to move at all. So even though you are playing time decay, you still want to form an opinion on in which direction the stock is most likely to move. Doing this, you have now given yourself another way of making the trade profitable. You are playing for a lack of movement but now you can still win if you pick the right direction. This scenario presents you with two ways to win and only one to lose.

Now that you have picked which at-the-money strike you are going to sell and you have picked your anticipated stock position, you still have a decision to make. Do you do the call vertical spread or the put vertical spread? Remember, both the vertical call spread and vertical put spreads allow you to participate in either stock direction. For the bulls, you can buy a vertical call spread or sell a vertical if you think that the stock will go up.

For the bears, you can buy a vertical put spread or sell a vertical call spread.

There are two choices to decide from for each direction. One is a purchase. The other is a sale. The best way to decide which one to do, other than your own style or comfort, is a simple risk/reward analysis. By selecting an at-the-money option to sell as part of a vertical spread, an investor can execute a time decay play with a hedged position.

Using Vertical Spreads as a Volatility Play

Vertical spreads are also usable as a volatility play. We stated earlier that an at-the-money option has more extrinsic value than other options in its expiration month. This is due to a number of contributing factors including time and largely volatility. An option’s dollar sensitivity to movements in implied volatility is known as Vega. Obviously, an at-the-money option will have a higher Vega (volatility sensitivity) than an in-the-money or out-of-the-money option in the same month.

As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option. As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option with a lesser Vega.

Conversely, the at-the-money option will lose value at a greater rate than an in-the-money or out-of-the-money option should implied volatility decrease. The question is how to use the vertical spread to take advantage of anticipated movements in implied volatility. Remember, the vertical spread affords you the luxury of being hedged on either side of the trade – both as a buyer and as a seller of the spread.

If you think that implied volatility is likely to increase, you can set up a vertical spread by buying an at-the-money option and selling either the in-the-money or out-of-the-money option against it. If you feel that implied volatility will decrease, you can set up a vertical spread by selling an at-the-money option and buy either an out-of-the-money or an in-the-money option against it.

To set it up, you would follow the same guidelines for setting up a vertical spread to take advantage of time decay. Decide which direction you feel the stock would most likely move. If you feel it is likely to rise, you must decide between buying a vertical call spread and selling a vertical put spread.

Either way, the spread will have to be constructed with the at-the-money option being long if you feel volatility will increase or short if you feel volatility will decrease. If you feel the stock would most likely fall, you will have to decide between buying a vertical put spread and selling a vertical call spread. Either way, the spread must be constructed with the short option being the at-the-money.

As you can see, the vertical spread is not restricted to directional scenarios. It is very versatile allowing the investor several choices among a diverse group of potential uses. It also affords limited risk, albeit limited profit potential, to the buyer and the seller.

Dec

23

Volatility

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To get a firm grasp of volatility’s effect on vertical spreads, let us examine three spreads against different implied volatilities while keeping the stock price constant at 67 ½. These are the 60 – 65, 65 – 70 and 70 – 75 call spreads.The chart below illustrates how volatility movements affect in-the-money, at-the-money and out-of-the-money vertical spreads.

In-the-Money Vertical Spreads

Looking at the in-the-money spread (June 60 – 65), we see that as volatility increases, the value of the spread decreases. This is because with the increased volatility, the stock has a greater tendency to move. That brings a higher probability of the stock moving to a price where the June 60 – 65 call spread will no longer be in-the-money.

To adjust for higher volatility risk, the spread will have less value. A general rule of thumb is that as volatility increases, the value of an in-the-money vertical spread decreases. Conversely, an in-the-money vertical spread’s value increases as volatility decreases.

At-the-Money Vertical Spreads

A change in volatility has very little effect on the at-the-money vertical spread (June 65 – 70). With the stock price located equidistant from the two strikes, each strike’s volatility component will be very similar. Therefore, both options will increase equally once volatility increases. Being long on one and short on the other, the increase in values will offset each other so the spread’s value will hold fairly constant. When volatility increases or decreases, the value of an at-the-money vertical spread will stay reasonably constant.

Out-of-the-Money Vertical Spreads

The out-of-the-money vertical spread (June 70 – 75) has the opposite effect of the in-the-money vertical spread (June 60 – 65). As volatility increases, the value of the out-of-the-money vertical spread will increase. This is because the increase in volatility assumes that the stock price is more likely to move. Thus, the out-of-the-money vertical call spread is more likely to finish in-the-money.

Because of this spread’s increased potential to finish in-the-money, its value will increase. The spread’s value will decrease if volatility decreases. On the other hand, an out-of-the-money vertical spread’s value increases when volatility increases.

The chart below illustrates what happens to option Deltas when volatility increases or decreases.


When trying to estimate how your spread will change in price with volatility movement, you must understand how the price and Delta of both of your options – long and short – will act.

It bears repeating again that each spread is different and will act differently depending on where the stock is in relation to the spread and what implied volatility does.

Median Value

An important thing to note is that when volatility increases, spreads crunch to their median value. For example, the median value of a $5.00 spread will be $2.50 while a $10.00 spread will have a $5.00 median value.

Crunching to the median value means that a $5.00 spread with a median value over $2.50 will lose value and head toward the median price. That happens with an increase in volatility. Meanwhile, increased implied volatility will make a spread with a value less than $2.50, increase in value and rise toward median value.

When implied volatility decreases, the value of a $5.00 spread will move away from the median price of $2.50. Therefore, when implied volatility decreases, all the spreads valued above $2.50 will increase in value toward maximum value. Spreads valued below $2.50 will lose value and head toward $0.

The Effect of Time

Time affects the spread differently depending on where the stock is. Look at the QCOM 65 – 70 call spread. Look at the spread’s reaction to the passing of time with the stock price of $65.50.

The chart below shows what the spread’s value does as expiration approaches.

With the stock at $65.50, the spread has $.50 of intrinsic value. Holding the stock price frozen at $65.50 until expiration, the spread would be worth $.50. The table above shows that the spread loses value as time passes and decreases in value toward its $.50 intrinsic value.

Next, look at the 65 – 70 spread’s reaction to the passage of time with the stock priced at $67.50.

With the stock price located directly in between the two strikes, the price of the spread holds at approximately $2.50 throughout the passing of time. Take note that time has very little effect on a vertical spread when the stock price lies halfway (equidistant) between the two strikes of the spread.

Now, set the stock price at $69.50 and observe how the spread reacts over time.

This spread increases in value as time passes. With the stock at $69.50, the spread has an intrinsic value of $4.50. If the stock held at $69.50 until expiration, the spread would be worth $4.50 because that is the amount of the spread’s intrinsic value. As time passes, the spread’s value will increase to finally reach $4.50 at expiration.

In conclusion, time’s effect on a vertical spread is contingent on where the stock is in relation to the spread.

Dec

22

Getting Out or Rolling the Position

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The selection and management of a vertical spread are only two-thirds of the game. Closing out, rolling or morphing the position has to be analyzed and executed with the same due diligence.Looking at the closing out of a vertical call spread, we find there are three possible outcomes. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In order to close out the spread, an investor would just let it expire. Both options finish out of the money so there is no residual position left over.

If the spread finishes fully in-the-money (at maximum value), meaning both options in-the-money, both options are exercised. You will exercise your long call and your short call will be assigned. They cancel each other out leaving you with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.

Investors encounter a difficult scenario when a stock closes in between the two strikes of the spread. This creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money. When both options expire in-the-money, they are both exercised. One creates a long stock option, the other a short position canceling each other out. This is not the case here. The option that is in-the-money leaves a residual stock position. Since the other option is out-of-the-money, it cannot offset the residual stock position created by the expiring in-the-money option.

Two actions are possible in this scenario. One involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. This may be the best thing to do in order to avoid naked, unlimited risk.

If you only trade out of the in-the-money option, you run the risk that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. This risk is short-lived because you are doing this late on expiration day of the expiring month. If this happens, you will be naked in the residual stock position.

If there is still time, you can always trade out of the option, but that is very risky. If the stock is at a relatively safe distance from the out-of-the-money option, you may want to just close out the in-the-money option and let it expire worthless.

The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option. Remember, this takes place at the very end of the day on expiration day. These options only have minutes of life left. The risk is somewhat mitigated, but still there nonetheless.

The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, it is best to trade out of the spread entirely.

As stated before, if the stock closes either with the spread fully in-the-money or out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position.

We discussed how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expiration process. You must remember that if you are going to accept a residual stock position, you must be able to afford it.

If you have 10 July 50 calls and you exercise them, you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.

Dec

21

Construction & Value of a Vertical Spread

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Construction of a Vertical Spread

Construction of a vertical spread occurs with the purchase and sale of a call (put) in the same stock and in the same month. The only difference between the two options is the strike price. For example, an investor would construct a vertical spread by purchasing the IBM June 55-call while selling the June IBM 60 call. This trade would be called the IBM June 55 – 60 call spread. Similarly, a purchase of the IBM July 45 put and sale of the IBM July 60 put would be called the IBM July 45 – 60 put spread.

The key to the constructing these vertical spreads is choosing options in the same stock and month, but different strikes and in a 1 to 1 ratio. That is, you must purchase one option for every one you sell or sell one option for every one you buy.

Value and the Vertical Spread

A vertical spread’s maximum value is the difference between the two strikes. For example, the maximum value of the June 55 – 60-call spread mentioned previously is $5.00. [60 – 55] = $5.

Using the June 55 – 60-call spread example, we will set the date to June expiration on Friday. On that day, all the June options will expire and the options will be worth parity, as all of the extrinsic value will have eroded away.

Where does the spread get its value? From its two components – the call (put) you buy or the call (put) you sell. Look at the spread’s value with a couple of different closing stock prices. If the stock closes at $55, then both the 55 strike and the 60 strike will be out of the money and worthless. The value of the spread will be zero since both options are worth $0. If the stock closes at $57.50, the June 55 calls will be worth $2.50. The June 60 calls will be out of the money and thus worthless, therefore the spread will be worth $2.50 (June 55 call $ 2.50 – June 60 call $0).

If the stock closes at $60.00, then the June 55 calls will be worth $5.00. Meanwhile, the June 60 calls will be worth $0. This means that the spread will be worth $5.00 (June 55 call $ 5.00 – June 60 call $0). This is the maximum value of the spread. Note that the maximum value is identical to the difference between the strikes.
As the stock goes higher, the June 60 call becomes in-the-money and gains intrinsic value. For every penny that the stock increases in value, the June 55 calls and June 60 calls gain value equally, keeping the $5.00 spread between the two strikes constant.

To see this, refer to the Table below.

The difference between the strikes is the maximum value of all vertical spreads regardless of the distance between the two strikes. It does not matter whether the spread is $5.00 wide, $10.00 wide, $20.00 wide, or even $50.00 wide. Its maximum value is the difference between the two strikes. Further, the vertical spread’s maximum value (the difference between the two strikes) holds true for vertical put spreads as well as vertical call spreads. Look at our other example, the July 45 – 60 put spread.

Again we set time forward to Friday, July expiration. We set the stock closing price at $60.00. At $60.00, both the July 45 puts and the July 60 puts will be out of the money and thus worthless. With the July 45 puts and July 60 puts worthless, the spread is also worthless (July 60 put $0 – July 45 put $0). If the stock finishes at $52.50, then the July 60 puts will be worth $7.50 while the July 45 puts will still be worthless. In this scenario, the July 45 – 60 put spread will be worth $7.50 (July 60 puts $7.50 – July 45 puts $0). If the stock finishes at $45.00, then the July 60 puts will be worth $15.00 while the July 45 puts will be worth $0.

At this level, the spread is worth $15.00 (July 60 puts $15.00 – July 45 puts $0). This is the maximum value of the spread. As you can see, it is identical to the $15.00 difference between the strikes.

As the stock lowers, the July 45 puts become in the money and gain intrinsic value. For every penny that the stock decreases in value, the July 60 puts and the July 45 puts will gain value equally, keeping the $15.00 spread between the two strikes constant. To see this, refer to the table below.

As stated, the maximum value of a vertical spread is the difference between the two strikes while the minimum value of the spread is, of course, $0. This means that in this strategy, both the buyer and the seller have a limited, fixed maximum loss.

The buyer can only lose what he spent. Therefore, if the buyer spent $2.20 to purchase the August 35 – 40-call spread, the most he can lose is the $2.20 he spent.

For the seller, the maximum loss is the difference between the maximum value of the spread (difference between the strikes) and the amount of money received for the sale of the spread. For example, if you were to sell the August 35 – 40-call spread for $2.20 then your maximum loss will be $2.80. Remember, the maximum value of the spread is the difference between the 2 strikes or $5.00 (40 – 35).

The difference between the maximum value of the spread ($5.00) and the amount the seller received for the sale ($2.20) leaves a $2.80 maximum loss.

Below, the chart shows the potential amount of money, both profit and loss, that can be made or lost by both the buyer and the seller.

It is important to understand and remember that vertical spreads have both a limited profit and a limited loss scenario for both the buyer and the seller.

Dec

20

Intrinsic Value and the Vertical Spread

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An investor must always keep in mind that vertical spreads have an intrinsic value. This means it is possible to consider them “in the money.” If a vertical spread has an intrinsic value, it can also have an extrinsic value. Unlike maximum intrinsic values that equal the difference between the strikes at expiration, maximum extrinsic value deviates from spread to spread based on several factors.During a vertical spread’s life, its price will fluctuate between zero and the value of the difference between the two strikes. An investor can determine the price of the spread, at any given time, by the location of the stock and the time until expiration.

At expiration, what remains for the two options is the intrinsic value of each. Therefore, the value of the spread is the difference between each option’s intrinsic values at expiration.

Because vertical spreads have an intrinsic value, the term “moneyness” applies to them. Moneyness refers to whether or not and by how much an option, or a vertical spread, may be in the money or out of the money. This is a term used mostly by floor traders, but is still worth noting here.

Vertical Call Spread and Vertical Put Spread Value

Spreads with intrinsic value are considered in the money. How can you identify the value of a vertical call spread or a vertical put spread? Compare the stock price to the strike prices.

Look at any vertical call spread. If the stock price is above the lower strike of the spread, the spread is in the money. In the Feb. 50 – 55-call spread, if the stock is trading at $52.00, then the spread would be in the money by $2. This is because if the spread expired today, the Feb. 50 calls would finish $2.00 in the money. The Feb. 55 calls would finish worthless because they are out of the money. The spread, however, would be in the money with a value of $2.00.

The rule is similar for determining whether or not a spread is out of the money. If the stock price is lower than the lower strike of the spread, the spread is out of the money. Again, looking at the Feb. 50 – 55 call spread, if the spread expired today and the stock price closed at $48.00, (lower than the lower strike) then the spread would be out of the money, thus the spread will be out of the money. If the stock is trading at the same price as the lower strike price, the spread is considered at the money.

For vertical put spreads, a spread is determined to be in the money if the stock price is lower than the higher of the two strikes of the spread. For example, look at the Sept. 40 – 45 put spread. If the stock closes at $42.00 on expiration day, the Feb. 45 put would end up in the money and worth $3.00. The Feb 40 puts would be out of the money creating a $3.00 intrinsic value for the spread. Since the spread has an intrinsic value, it is in the money.

A vertical put spread is out of the money if the stock price is higher than the higher strike of the spread. So, going back to our Sept. 40 – 45 put spread example, if the stock was to close at a price of $46.00 (higher than the higher strike) then both the Sept. 40 and 45 put will expire worthless. Thus the spread will be worthless and out of the money.

A vertical put spread is considered at-the-money when the stock price is equal to the higher strike price.

Dec

19

Two Types of Vertical Spreads

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There are two types of vertical spreads – the vertical call and put spread. Each one allows investors to do two things. They can buy it and long the vertical spread. They can also sell it and short the vertical spread. Investors often utilize these measures to take advantage of directional stock plays, which capitalize on anticipated stock movements.

Vertical Call Spreads

When an investor is confident that a stock is likely to go up, they will employ a bull spread. It can be set up in two ways. The first is through calls. In this case, a bullish investor would buy a vertical call spread (bull call spread) by purchasing a call with a lower strike price and selling a call with a higher strike price.

Vertical Put Spreads

The second way to construct a bull spread is through puts. A bullish investor can sell a vertical put spread (bull put spread) hoping to profit from an increase in the stock’s value. The investor would sell a put with a higher strike price and buy a put with a lower strike price.

Look at the P&L chart of a Bull Spread below.

If an investor feels that a stock may be increasing in value, they might put on a bull spread by either buying a vertical call spread (bull call spread) or selling a vertical put spread (bull put spread).

Bear Spreads

On the other hand, when an investor feels that a stock is likely to trade down, they will employ a bear spread. The term “bearish” refers to a negative outlook on a stock’s future movement. To take advantage of this expected downward movement, an investor can put on a bear spread in two ways.

The investor can purchase a vertical put spread (bear put spread) by purchasing a put with a higher priced strike and selling a put with a lower priced strike. The investor can also construct a bear spread by selling a vertical call spread (bear call spread) by selling a call with a lower strike price and purchasing a call with a higher strike price.

Look at the P&L diagram for a Bear Spread below.

Two fundamentals are universal to all vertical spreads. You can determine a vertical spread’s maximum value by taking note of the difference between the two strikes and vertical spreads have intrinsic value.

Dec

18

December 16 Market Talk – Part 1

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Dec

18

December 16 Market Talk Part 2

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Dec

18

Spread Prices

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Vertical spreads will trade between its minimum and maximum values – zero and the difference between the two strikes. In the case of a vertical call spread, the spread will trade closer to zero when the stock trades closer to or lower than the lower strike price. The spread will trade closer to maximum value when the stock trades closer to or higher than the higher strike price.

Let us refer back to the August 35 – 40 call spread chart. In the column marked “August 35 – 40 call spread closing price,” you can see that with the stock at $35.00, the spread is worthless. As the stock price climbs toward 40, the call-closing price increases until finally it reaches its maximum.

Remember, this maximum gain occurs at expiration. Before that, the spread will trade with a premium.

Starting from a stock price of 37 ½, a price located directly between the two strikes, (using our example of the August 35 – 40 call spread) we can see the approximate value of the spread is roughly $2.50. This is because the August 35 calls and the August 40 calls are equidistant from the current stock price of $37.50. Being equidistant from the stock, both the August 35 and 40 calls will have almost the same amount of extrinsic value in them.

Thus, the extrinsic values of the two options cancel themselves out since you are long one call and short the other. This would leave each option value consisting of only intrinsic value. With the stock at $37.50, the value of the August 35 – 40 call spread will be $2.50. The August 35 calls will have $2.50 in intrinsic value while the August 40 calls will have $0 in intrinsic value. The difference gives you a spread with a value of $2.50.

A general rule of thumb is if the stock price is located evenly between the two strike prices, the vertical spread should be worth roughly half of the value of the distance between the two strikes. This will be true for vertical put spreads as well as call spreads. From this rule, we can roughly estimate the vertical spread’s price per different stock prices.

For vertical call spreads, if the spread is worth roughly half of the difference between the two strikes with the stock price directly between the two strikes, then as the stock falls to lower strike and beyond, the spreads value will decrease and move closer to $0. Time left until expiration and volatility will dictate how close and how quickly it will approach $0. On the other side, as the stock climbs toward and above the upper strike, the spread’s value will increase toward its maximum value described by the difference between the two strikes.

For vertical put spreads, as the stock price decreases toward the lower strike price, the spread will increase in value and approach its maximum value as defined by the difference between the two strikes. As the stock price increases toward the higher strike, the spread will decrease in value and will approach $0. Again, time until expiration and volatility will determine how quickly and how close the spread will approach $0.

Factors that Affect Spread Pricing

The determination of pricing as described above works in most cases. Be aware that it assumes that the implied volatility in both the 35 and 40 calls is the same. Most often, these two options will have a slightly different implied volatility.

This intra-month difference in implied volatility values through different strikes is known as a vertical volatility skew. The reason the markets run volatility skews is to make sure that out of the money options have enough premium in them to justify the individual option’s risk/reward scenario.

Whatever factors affect the vertical spread, they are contingent on where the stock is in relation to the spread. Changes in implied volatility affect the price of a spread as stated above but the position of the stock in relation to the strikes of the spread is a key determinate of price.

Dec

17

Market Talk Dec 16 2007

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Part 2

Dec

14

A Recap with Special Insights

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Vertical spreads can have various names. The same vertical spread could be called several different things by several different people. We have used two terms only: vertical call spread and vertical put spread. Each of these two spreads allows for two positions, long and short.

The long vertical call spread is constructed by buying one call option with a lower strike price while simultaneously selling another call option in the same month with a higher strike price. In a one to one ratio this trade, the long vertical call spread, is labeled a bullish trade. This means that when engaging into a long vertical call spread, the investor expects the stock to increase in value. An investor who engages in a trade with the expectation of the stock going up is said to be bullish. Thus, a long vertical call spread is a bullish trade.

For example, you are long a vertical call spread if you buy 10 August 35 calls and sell 10 August 40 calls. The proper way to describe this would be “long the August 35 – 40 call spread.” Using our previous example of the August 35 – 40 call spread, we assume that you bought the spread for $2.80. At expiration, you know that you can lose a maximum of $2.80 if the stock closes at $35.00 or below. At expiration, you will gain your maximum profit if the stock is $40.00 or over. Your maximum profit is defined as the difference between the two strikes minus the amount you paid for the spread.

Vertical spread’s maximum profit = (difference between the two strikes) – (amount paid for spread).

In this case, the difference between the two strikes equals $5.00. That $5.00 minus the $2.80 you spent on the spread leaves you with a maximum potential gain of $2.20, and represents a 78.5% return. The potential maximum loss is $2.80 or the full value of the investment.

The chart below shows what this spread will do over the course of a range of stock values.

A short vertical call spread is constructed by selling a call with a lower strike price, while simultaneously buying a call in the same month with a higher strike price. Since owning a vertical call spread created a long position for the owner, then the seller of the vertical call spread must be short.

An investor who takes a short position anticipates a decrease in the price of a stock and is considered to be bearish on the stock. Thus, a short vertical call spread is considered a bearish position.

Using our example, say you are short 10 August 35 calls and long 10 August 40 calls. The short vertical spread is set up in the proper ratio and in the same month. For the sale of the spread you received $2.80. Your maximum potential gain is the $2.80 that you received from the sale and would be obtained if the stock closed $35 or below.

The maximum loss is calculated by taking the difference between the two strikes and subtracting the sales price of the spread from it. The difference between the two strikes is $5.00 (40-35). From that we subtract the price of the spread which is $2.80 and we are left with $2.20. This $2.20 is the maximum potential loss for a seller of this spread. The formula is given as: The difference between the two strikes – the price of the spread = total potential maximum loss.

The maximum profit for the seller of a vertical call spread is attained when the price of the stock closes at or below the lower priced strike. And the maximum loss is attained when the stock closes at the higher strike.

The vertical put spread functions in much the same way as the vertical call spread just in the opposite direction. Like the vertical call spread, the construction of the vertical put is done in a one to one ratio. The vertical put spread is constructed by purchasing one put and simultaneously selling another put in the same month but in a different strike.

A long vertical put spread is considered to be a bearish trade. This means that the purchaser of a vertical put spread is expecting the stock to go down. Further, a long vertical put spread is considered a debit spread which simply means that the purchaser had to put out money to buy the spread. Now, if the stock proceeds down, the spread’s value will expand. As stated before, a spreads maximum value is equivalent to the difference between the strikes. On the other hand a spreads minimum value is $0.

In the case of a put spread, maximum value is attained when the stock trades at or below the lower strike. Conversely, a put spread’s minimum value is attained when the stock trades to the higher strike.

For example, suppose we purchase the August 50-55 put spread for $3.00. To set up this trade, we would have bought the August 55 put and sold the August 50 put. If the stock trades down to 50 or below at expiration, the spread will be worth its maximum value of $5.00 (difference between the two strikes: 55-50).

Since you bought the spread for $3.00 and it is now worth $5.00, you have a $2.00 profit which represents a 66.6% profit on your $3.00 investment.

On the downside, the most you can lose is the $3.00 you spent for the spread and this will happen if the stock closes $55 or above. If the stock was to close at $55, the August 55 put would be worthless because it would be equal to the stock price thus valueless. The August 50 put would also be worthless being that it is $5.00 out-of-the-money. The difference between these two values would obviously be $0. Below, the chart shows the value of the spread at different stock prices.


A short vertical put spread is constructed by purchasing a put with a lower strike price while simultaneously selling a put with a higher strike in the same stock in the same month and in a one to one ration. For example buying one Feb 65 put while selling one Feb 70 put or buying 10 May 20 put while selling 10 May 30 put. It is considered to be a bullish trade because the seller expects the stock to go up or increase in value. Further, it is considered a credit spread meaning that you receive cash into your account upon execution of the trade.Say you were to sell the June 50 – 60 put spread for $5.50. As the seller, your maximum profit will be the $5.50 you received for the sale of the spread. The maximum profit will be attained if the stock closes at $60.00 or above. At that level, both the June 50 and 60 puts will be worthless because both will be out-of-the-money. Thus, the spread will have no value.

The maximum loss of the trade will be defined by the difference between the two strikes minus the amount you received from the sale of the spread. In this case, the difference between the strikes is $10.00 (60 strike – 50 strike). The spread was sold for $5.50 so $4.50 is the maximum loss of the position to the seller.

In conclusion, vertical spreads provide the buyer and the seller an excellent percentage return while, at the same time, provide limited loss scenarios. Vertical spreads allow for two types of bullish trades, the purchase of a vertical call spread or the sale of a vertical put spread. On the other hand, vertical spreads offer two bearish trades; the purchase of a vertical put spread and the sale of a vertical call spread.

So, if you want to take advantage of a directional stock movement (either up or down) but you are not interested in taking a longer term, possibly capital intensive position, then look to using the vertical spread due to its favorable risk reward scenario.

Dec

13

An Imaginary Spread Scenario

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Let’s put together what we’ve been talking about, develop an imaginary spread scenario and set it in real life events.

In October, let’s say that you begin to hear about IJK stock. It looks interesting, so you then use a variety of sources to learn about IJK: news, charts, outside analysts, internet research etc. From your investigations you decide that this stock is poised for a strong upward move and you’d like to take advantage of it.

However, each share is $50.00 and you question whether you want to put out the capital for enough shares to make the trade worthwhile.

Now is the time to investigate IJK spreads. Since you are bullish on the stock, you investigate the bullish plays of the call spreads and the put spreads. You check the pricing of both since you are aware that implied volatility and time decay will affect both your purchase price and your selling price if you decide to sell out the spread before expiration.

Let’s say that you set the spread’s maximum potential gain at $10.00 using our formula. Then you decide you want to buy a call spread, so you buy 10 IJK Nov. 50 calls and sell 10 IJK Nov 60 calls. The spread is called Nov. 50-60. The spread’s cost is $3.50, which means you pay $3500 for the trade, inexpensive when you consider that to purchase 1000 shares of IJK stock would have cost you $50,000!

Now, you wait and follow the stock price of IJK. If you hold the position to expiration, you face the following losses or gains.

First, if the stock does not move up as you expected and stays at $50 or decreases in value, your spread is worthless and you lose the $3500 that you paid for the spread. Second, if the stock begins to move up, you first recoup your investment and then move into profits. After the stock has moved up $3.50 you are at the breakeven point. Every money advance after that represents profit.

The chart below represents the spread’s losses and gains and your total profit
This chart is based on stock prices at expiration Friday in November. Until then the spread’s value fluctuates between $0 and its maximum (the difference between strike prices) of $10.00At any time until expiration, you can sell out of the spread but what you receive for the price may be influenced by implied volatility and time decay and that will change your profit or loss. If you hold the spread until expiration and your bullish lean proves true, your maximum profit on your $3500 investment is $6500.

You paid $3500 for the spread and received $10,000 at expiration with the stock at $60.00. That represents a $6500 profit which is a 186% return.

If you had invested $50,000 for 1000 shares of IJK and at expiration sold the stock for $60,000, your profit is $10,000 for a 20% return.

For many investors the reward/risk scenario of the spread is attractive because investors can limit the capital at risk and the time of risk/reward exposure. The spread also offers protection if your lean is bullish or bearish. Finally, the spread has the potential of a large percentage return on investment.

Dec

12

Weekly Market Talk Dec 9, 2007

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